Hopeful bears eye the VIX

Commentary: One indicator down, one to go

By

LawrenceG. McMillan

Columnist

MORRISTOWN, N.J. (MarketWatch) — The stock market, as measured by the Standard & Poor’s 500 Index and many other indexes, reached massive overbought levels through Tuesday’s trading. But Wednesday’s selloff has raised alarm bells. Is the party over, or is this just a buying opportunity?

We’ll try to answer that question.

The market had reached ridiculous extremes. It is a classic example of a new bullish phase that continues to rise while the indicators are becoming more and more overbought. Analysts were trying to invent new ways of saying the same thing day after day: “The market is overbought, but not yet on a sell signal.”

One even likened the market action to that of the movie “Groundhog Day” — the same thing every day. Now we may finally have broken that spell and generated some of those sell signals.

The S&P 500
SPX, -0.23%
itself had been contained within a range of 1,495 to 1,515 for about two weeks. Then last week, it broke out to new highs, above that 1,515 level. These prices were last seen in late 2007. In a more volatile environment, such an upside breakout would engender a great deal of momentum, dragging in buying from the sidelines. That didn't happen. Rather, the market continued to rise at a slow and narrow pace.Technically, that 1,495 to 1,515 level should provide good support for any pullbacks. In fact, a close below 1,495 would be negative, and would probably signal the onset of a more severe correction. Below there, support exists at 1,460-1,470, the area of the 2012 highs.

Meanwhile, the equity-only put-call ratios have struggled to find their way. Normally, with the market making new multiyear highs, call buying would be extreme, and the put-call ratios would be racing lower on their charts. Actually, there is plenty of momentum-chasing call buying. But there is another factor: the cheapness of put options has enticed investors to buy puts to protect portfolios. Hence put buying has been fairly heavy, even though stock prices are making new highs. That is a distortion caused by hedging, and it made the put-call ratios flatten out and trade sideways.

When hedging activity is prominent, it is difficult — if not impossible — to interpret contrary indicators in their traditional form.

Market breadth has been steadily strong until today. Thus, our breadth oscillators have remained on buy signals all along, although they too were in overbought territory. Then, today, they rolled over to sell signals as declines outnumbered advances by a large margin.

Today was also a “90% down volume” day — the first 90% day of any kind since Jan. 2. The advance has been so controlled and steady that there hasn't been a single “90% day” during that time. That is quite unusual. It is true that a “90% down volume day” is indicative of a short-term oversold climax, and there might be a reflex rally. But in the broader sense, if the frequency of 90% days starts to increase, that is negative for the stock market as a whole.

This past week, the volatility indexes
VIX, -0.08%VXO, +0.49%
traded at their lowest levels since April of 2007. As long as VIX is this low, it might be considered overbought, but it is not a prohibition to higher stock prices. We have been noting that 15 is the level of VIX that determines the difference between a continued bull market (below 15) and a correction (above 15). Today, VIX exploded to the upside, closing at its high – at 14.68. That’s not above 15, of course, so we are still not registering a sell signal for stocks from VIX.

The construct of the VIX futures has remained bullish all along. That is, the VIX futures have been trading with large premiums, and the term structure has been sloping steeply upward. Today put a dent in that structure, with futures losing plenty of premium, and the term structure flattening considerably. Even so, we would rate the construct as bearish, but if the near-term futures begin trading at a discount, and they are trading at higher prices than the longer-term futures that would be another negative sign.

We have been saying that we didn’t want to short this market before confirmed sell signals arrived, because it was too powerful. But now we have a confirmed sell signal from market breadth. If VIX closes above 15, that would be enough to expect a more sizable correction, in our opinion.

If the S&P 500 falls below 1,495, that would be an even more important negative sign.

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